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PRACTICE OF INVENTORY

VARIATION METHODS IN
CORPORATE SECTOR OF
BANGLADESH
F- 504: Financial Accounting and Reporting

GROUP 02

APRIL 8, 2017
Prepared by:

Faisal Karim 34036

Nusrat Yasmin 34038

S.M. Samiul Islam 34045

Md. Ruhul Arefin 34046

Md. Mahafuj Rahman 34049

Prepared for:

Dr. H.M. Mosarof Hossain


Professor,
Department of Finance,
EMBA Program, University of Dhaka

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Letter of Transmittal

April 08, 2017

Niaz Patwary,
Lecturer,
School of Business,
North South University,
Bashundhara, Dhaka.

Subject: TRANSMITTAL MESSAGE

Dear Sir,

Here is the report that you asked us to conduct regarding Practice of Inventory valuation methods
in corporate sector of Bangladesh on 08 April, 2017

For this analytical study we conducted secondary researches primarily, i.e. browse
through different books, journals, articles and renowned web-sites for gaining knowledge about
manifold issues of inventory valuation techniques and contemporary events in Bangladesh.

We appreciate you for asking us to conduct this report.

Sincerely Yours,

Faisal Karim ______________________

Nusrat Yasmin ______________________

S.M. Samiul Islam ______________________

Md. Ruhul Arefin ______________________

Md. Mahafuj Rahman ______________________

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TABLE OF CONTENTS

1.0 Introduction .............................................................................................................................................................1


2.0 Inventory Costing Method .......................................................................................................................................1
2.1 Specific-identification ..........................................................................................................................................2
2.2 First-In-First-Out (FIFO) ........................................................................................................................................2
2.3 Last-In-First-Out (LIFO) ........................................................................................................................................2
2.4 Weighted average or simple average ..................................................................................................................2
3.0 Literature review .....................................................................................................................................................3
3.1 Introduction .........................................................................................................................................................3
3.2 Development of IAS -2 .........................................................................................................................................4
4.0 Methodology ...........................................................................................................................................................4
5.0 Discussion and Findings ...........................................................................................................................................5
5.1 Bangladesh Corporate Sector Inventory Valuation (Based on sample) ...............................................................5
5.1.1 mainstream inventory valuation method (based on sample) ......................................................................6
5.1.2 rationale of using Weighted Average-Cost method and fifo ........................................................................7
5.1.3 Consistency with Bangladesh Accounting Standard .....................................................................................7
6.0 Consequence of valuation method in the bottom line of a company .....................................................................8
7.0 Coclusion................................................................................................................................................................10
8.0 Reference ...............................................................................................................................................................11
1.0 INTRODUCTION

Inventory valuation is a subject of interest among business professionals since inventories


constitute a substantial portion of a firms assets and valuation of inventory can have a direct
bearing on the firms cash flows and presumably also on the firm's value. It is therefore
absolutely imperative to make proper valuation of a firms inventories. Valuation leads to a
primary issue in inventory accounting the cost flow assumption used to trace the movement of
costs into and out of inventory in other words, the costing method used to determine the value
of inventory. Needles and Powers (2012) state that the costing method plays an important role
while accounting for inventories, since the value of inventory determined by a costing method
affects a firms net income, cash flows and the amount of income taxes that the firm pays. This
paper thus addresses inventory costing methods in greater detail by identifying the prevailing
method of inventory valuation, consistency in application and harmonization with authoritative
accounting practices from the perspective of a corporate sector of Bangladesh.

Based on the findings, the study also attempts to reveal the level of uniformity and consistency in
inventory costing practices followed by firms of different corporate sectors in Bangladesh.

2.0 INVENTORY COSTING METHOD

Inventories are defined as products, partially completed products, raw materials and supplies - all
of which await the ultimate fruition of sales transactions. Inventories are the life of the business.
Inventories are necessary in order to generate sales and, in return, sales generate profit for the
business.

Inventories of retail businesses include goods purchased in final form with the intention of
reselling them. The inventories of manufacturing companies include raw materials, goods in
process and finished goods. The purchase prices of goods and raw materials vary. The cost of the
inventory at the end of an accounting period is crucial because of its effect on the cost of goods
sold and ultimately on the computation of profits. The lower the cost of ending inventory, the
higher is the cost of goods sold, and vice versa. Higher cost of goods sold will result in lower gross
profit and vice versa. Therefore, the choice of inventory costing method has a significant effect on
reported income.

A company uses either the perpetual or periodic inventory method to keep track of their inventory.
The valuation method used to estimate the cost of the ending inventory varies; namely,

Specific-identification,

First-In-First-Out (FIFO),

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Last-In-First-Out (LIFO), and

Weighted average or simple average.

2.1 SPECIFIC-IDENTIFICATION

Specific identification method is a common practice for firms with unique, high-value items as
inventories like automobiles, paintings, expensive jewelry and custom-made furniture. Cost for
such inventories is calculated by clearly identifying each individual inventory items and tracking
its movement in and out of stock. However, specific identification becomes impractical if items in
inventory are interchangeable. In such cases, firms generally assume the items sold and items
remaining in inventory by using the cost flow methods of FIFO, LIFO or Average-Cost.

2.2 FIRST-IN-FIRST-OUT (FIFO)

FIFO method is generally consistent with the physical flow of inventories in most of the
enterprises. It is based on the assumption that the earliest purchases are sold first and the more
recent purchases remain in ending inventory. This implies that FIFO method values ending
inventory at the current costs. This chronological cost flow of FIFO method conforms to good
business practice - particularly for items that deteriorate or become obsolete.

2.3 LAST-IN-FIRST-OUT (LIFO)

LIFO method, in contrast, does not coincide to the actual physical flow of inventory. LIFO method
assumes that the more recent purchases are the first to be sold and hence, ending inventory is based
on the costs of the earliest purchases. This method of valuation can result in realistic reported
profits since current costs is matched to current revenues. However, the value of inventories at
earliest prices can present an unrealistic picture of the inventorys current value under LIFO
method.

2.4 WEIGHTED AVERAGE OR SIMPLE AVERAGE

An alternative to the FIFO and LIFO method is the weighted-average cost method. The average-
cost system is appropriate where the inventory consists of units which are homogenous,
interchangeable and does not follow any specific pattern of physical flow. Under this method, the
value assigned to inventory is the average cost of all inventory items available for sale during the
period. Due to the technique of assigning average cost, this method smoothens the fluctuations in
the cost of inventory items.

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In brief, no one cost method is conceptually superior to any other for the valuation of inventories.
Companies, therefore, tend to choose a method which is unique to their own situation. The reason
companies adopt different costing methods may vary, but they usually involve three factors such
as the effect of each method on income statement, balance sheet and income tax. This implies that
inventory valuation methods can have major effects on the financial statements a reason why
many studies have been conducted regarding the choice, effects of the choice and rationale behind
the choice of these costing methods.

3.0 LITERATURE REVIEW

3.1 INTRODUCTION

Inventory problems are as old as history itself; but it was the turn of the 17th century that attempts
were made to employ analytical techniques in studying these problems. The initial impetus for the
use of mathematical methods in inventory analysis seems to have been supplied by the
simultaneous growth of manufacturing industries and the various branches of engineering,
especially industrial engineering.

Inventory decisions directly affect the value of cost of goods sold and consequently play a pivotal
role in determining the reported earnings of a company. As a result, a thorough analysis of
inventory valuation and related accounts can provide a basis for assessing the financial position of
a firm.

According to Walter inventory consist of goods held for resale of consumers, partially completed
goods in production, materials and supplies used in production. Inventory items are
acquired and sold continuously in merchandising business or acquired, placed in production,
converted into finished product and sold in a manufacturing business.

According to international financial reporting standard (IFRS), inventories are assets-

Held for sales in the ordinary course of business,


In the process of production for such sale; or
In the form of materials or supplies to be consumed in the production process or in the
rendering of services.

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3.2 DEVELOPMENT OF IAS -2

Since establishment to till, IAS-2 goes through a substantial development process, as shown in
Appendix-A: on the basis of situational requirements. Over the period development of
IAS-2 ensures standardized reporting of inventory value in the financial statement regardless of
nature of business.

IAS-2 requires that the amount at which inventory is stated in periodic financial statements should
be the total of the lower of cost and net realizable value of the separate items of inventory or of
groups of similar items. The standard also emphasizes the need to match costs against revenue,
and it aims, like other standards, to achieve greater uniformity in the measurement of income as
well as improving the disclosure of inventory valuation methods.

To an extent, IAS-2 relies on management to choose the most appropriate method of inventory
valuation for the production processes used and the company's environment. Various methods of
valuation are theoretically available, including FIFO, LIFO and weighted average or any similar
method (IONESCU, 2014). In selecting the most suitable method, management must exercise
judgment to ensure that the methods chosen provide the fairest practical approximation to cost.
IAS 2 does not allow the use of LIFO because it often results in inventory being stated in the
statement of financial position at amounts that bear little relation to recent cost levels.

4.0 METHODOLOGY

According to Bangladesh Accounting Standards (BAS) 1 companies should provide a summary of


significant
accounting policies that they apply in their organization in the notes to the financial statements
section of their annual reports (ICAB, 2008). As such, the accounting treatment and cost formulas
applied to determine the value of inventories of a company can be found in the annual reports.
Since annual reports are generally published by the companies to present information that will
reflect a cohesive financial picture of the organization and not for any research purposes, it can act
as secondary data sources for this study.

Annual reports of the selected companies were therefore studied to gather relevant data of their
inventory valuation methods.

The population selected to conduct this study includes 15 currently listed companies out of all
companies listed at the Dhaka Stock Exchange (DSE) during the year 2017. Data has been
systematically categorized into different industries, from where banks, financial institutions,
insurance firms, telecommunication firms along with debentures, corporate bonds, mutual funds
and treasury bonds were excluded from the sample on the basis of purposive sampling method.

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Since the focus of this paper is on inventory valuation practices, only those industries has been
selected for this study wherein, firms report inventories as part of their business processes.

Table 1: Sector wise population and sample distribution

Population Sample Percentage


Name of the Industry Total number of companies Number of companies
listed at DSE as of 2017

Cement 7 3 42
Food & Allied 18 5 28
Ceramics 5 2 40
Pharmaceuticals &
28 8 28
Chemicals
Textile 47 5 10
Total 105 23 22

5.0 DISCUSSION AND FINDINGS

5.1 BANGLADESH CORPO RATE SECTOR INVENTORY VALUATION (BASED ON SAMPLE)

Table 2: List of companies selected and the inventory valuation method applied

Companies Valuation Method


A. Cement
1. Heidelberg Cement Weighted Average Cost
2. Lafarge Surma Cement Weighted Average Cost
3. Meghna Cement Weighted Average Cost
B. Food & Allied
1. BATBC Weighted Average Cost
2. Apex Foods Not Disclosed
3. AMCL (Pran) Weighted Average Cost
4. National Tea Not Disclosed
5. Bangas Weighted Average Cost
C. Ceramics
1. Monno Ceramic Weighted Average Cost
2. Fu-Wang Ceramic Not Disclosed
D. Pharmaceutical
1. ACI Limited Weighted Average Cost
2. Beximco Pharma Weighted Average Cost
3. Renata Ltd. FIFO
4. Glaxo SmithKline Weighted Average Cost
5. Square Pharmaceuticals Ltd. Weighted Average Cost

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6. Keya Cosmetics Weighted Average Cost
7. Kohinoor Chemicals Weighted Average Cost
8. The Ibn Sina FIFO
E. Textile
1. H.R.Textile Weighted Average Cost
2. Metro Spinning Weighted Average Cost
3. Sonargaon Textiles Weighted Average Cost
4. Square Textiles Not Disclosed
5. Delta Spinners Ltd. Weighted Average Cost

The cross-sectional sample of companies used for the analysis indicate the adoption of popular
inventory costing methods like Weighted Average-Cost and FIFO across different sectors of
Bangladesh. Out of the 23 selected companies, a majority of 17 companies (73.91%) use the
Weighted Average-Cost method while 2 companies (11.76%) adopt the FIFO method to determine
the value of their inventories in Bangladesh, as shown in Table 2.

None of the companies selected for this study has been found to use the LIFO method to value
their inventories. However, the research did reveal that there are 4 companies (23.53%) in the
sample which did not disclose their inventory costing methods in their annual reports.

5.1.1 MAINSTREAM INVENTORY VALUATION METHOD (BASED ON SAMPLE)

Table 3: Summary of sample companys inventory valuation methods

Disclosed
Name of Industry Weighted-Average Cost FIFO LIFO Not Disclosed

Cement 3 0 0 0
Food & Allied 3 0 0 2
Ceramics 1 0 0 1
Pharmaceuticals 6 2 0 0
Textile 4 0 0 1

Sector-wise analysis from Table 3 reveals a definite use of the Weighted Average-Cost method
among most of the companies of the 5 industries selected as a sample for this analysis. However,
pharmaceuticals and chemicals industry is seen using the FIFO method - despite the predominant
adoption of the Weighted Average-Cost method in their respective sectors, based on our
pinpointed sample.

Therefore, it can be stated that whether it is a Cement, Textile or Food & Allied industries,
companies belonging to these sectors show the highest odds of employing the Weighted Average-
Cost method to value their inventories in Bangladesh.

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5.1.2 RATIONALE OF USING WEIGHTED AVERAGE-COST METHOD AND FIFO

Weighted Average-Cost method is mostly used because of its simplicity. This method provides a
consistent value for the inventories by merging the cost and output of both the previous and the
current period and allocates value to the ending inventory and cost of goods sold in such a way,
that the allocation falls between the values produced by FIFO and LIFO method. This implies that
the Weighted Average-Cost method avoids the high extremes of FIFO and low extremes of LIFO
and reports an income and tax amount somewhere between the two ends. Due to this averaging
technique, companies are able to dampen the effects of any increase or decrease in prices for a
prolonged period of time. Since Bangladesh has a history of increasing inflationary pressures the
Weighted Average-Cost method tends to be a reasonable choice for inventory valuation across the
different sectors of Bangladesh.

On the other hand, adoption of the FIFO method by the fact that: in a period of inflation FIFO
produces a higher net income because the lower unit cost of the first units purchased are matched
against revenue. A higher net income makes a company more favorable to external users and also
ensures management of income-based bonuses. As a result, some firms in Bangladesh adopt the
FIFO method for the valuation of their inventories. FIFO method is specifically suitable if the
inventory items are of a perishable nature. Also, inventory items that are prone to obsolescence
and variability may typically adopt the FIFO method for valuation purposes. Following this line
of argument, it can be stated from this study that companies from the pharmaceutical and chemical
sectors have purposely opted for the FIFO method on the basis of the delicate nature of their
inventories.

5.1.3 CONSISTENCY WITH BANGLADESH ACCOUNTING STANDARD

The widespread use of the Weighted Average-Cost method reported by this study does not
necessarily mean that this inventory valuation method is the optimal choice for every firm across
all sectors of Bangladesh. There is not one best method to determine the value of inventories. Even
accounting standard-setting bodies has not mandated any one method to be the most conceptually
correct method to value inventories.

In Bangladesh, accounting rules relating to inventory valuation has been described as Bangladesh
Accounting Standards (BAS) 2 Inventories and has been adopted by the Institute of Chartered
Accountants in Bangladesh (ICAB) as on or after January 2007. Closely modeled on International
Accounting Standards (IAS) 2, BAS 2 Inventories outlines the specific identification, FIFO and
Weighted Average-Cost as acceptable methods of determining the cost of inventory in Bangladesh.
Following IAS 2, the use of different cost formulas for inventories with different characteristics
has also been authorized by BAS 2. However, the cost formula of LIFO is not allowed for use by
any company in Bangladesh under the directive of BAS 2 Inventories.

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Findings of this study indicate that the selected firms in the sample has complied with authoritative
accounting practices in Bangladesh, since they reportedly follow the benchmark treatments of the
Weighted Average-Cost and FIFO method to value their inventories. However, a certain level of
disharmony is also reported by this study among firms within the same industry. Due to
differences in business circumstances, practice of alternative accounting
treatments have been justified among different firms. Nevertheless, some prior research claims
that firms of the same industry should adopt the same accounting treatment so that harmonization
of practices can be achieved which implies that uniformity regarding inventory valuation practices
between firms of the same sector in Bangladesh has not been achieved in certain cases.

6.0 CONSEQUENCE OF VALUATION METHOD IN THE BOTTOM LINE OF A COMPANY

A company's choice of inventory valuation will affect the company's income, cash flow and
balance sheet.

Income effect - Inventory and cost of goods sold are interdependent. As a result, if LIFO
method is used in a rising-price and increasing-inventory environment, more of the higher-
cost goods (last ones in) will be accounted for in COGS as opposed to FIFO. Under this
scenario, net income will be lower compared to a company that used FIFO accounting.

Cash flow effect - If we lived in a tax-free world, there would be no cash flow difference
between inventory-accounting methods. Unfortunately, we do pay taxes. As a result, if a
company uses the FIFO method in a rising-price and increasing-inventory environment, it
will have to generate a lower COGS and a higher net taxable income, and pay higher taxes.
Tax expenses are a real cash expense and lower a company's cash flow.

Working Capital - Working capital is defined as current assets minus current liabilities. If
one method produces a higher inventory value in the income statement, the working capital
will increase.

In order to make an analytical judgement regarding the influence of embracing multiple inventory
valuation methods in financial statement, we have formed hypothetical scenario where company
Xs inventory have been examined based on multiple variation methods.

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Monthly Inventory Purchases*
Month Units Purchased Cost/ea Total Value
January 1,000 CR. 10 CR. 10,000
February 1,000 CR. 12 CR. 12,000
March 1,000 CR. 15 CR. 15,000
Total 3,000
Beginning Inventory = 1,000 units purchased at CR. 8 each (a total of 4,000 units)

*Note: All calculations assume that there are 1,000 units left for ending inventory:
(4,000 units - 3,000 units sold = 1,000 units left)

Income Statement (simplified): January-March*


Item LIFO FIFO Average
Sales = 3,000 units @ CR. 20 each CR. 60,000 CR. 60,000 CR. 60,000
Beginning Inventory 8,000 8,000 8,000
Purchases 37,000 37,000 37,000
Ending Inventory (appears on B/S)* 8,000 15,000 11,250

COGS CR. 37,000 CR. 30,000 CR. 33,750


Expenses 10,000 10,000 10,000
Net Income $13,000 $20,000 $16,250
What we are doing here is figuring out the ending inventory, the results of which depend on the accounting
method, to determine COGS. All we've done is rearrange the above equation into the following:

Beginning Inventory + Net Purchases - Ending Inventory = Cost of Goods Sold


LIFO Ending Inventory Cost = 1,000 units X CR. 8 each = CR. 8,000

Remember that the last units in are sold first; therefore, we leave the oldest units for ending inventory.

FIFO Ending Inventory Cost = 1,000 units X CR. 15 each = CR. 15,000
Remember that the first units in (the oldest ones) are sold first; therefore, we leave the newest units for
ending inventory.
Average Cost Ending Inventory = [(1,000 x 8) + (1,000 x 10) + (1,000 x 12) + (1,000 x 15)]/4000 units

= CR. 11.25 per unit

1,000 units X $11.25 each = $11,250

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7.0 COCLUSION

The overall results of this study demonstrate that the Weighted Average-Cost method is
particularly practiced across all nonfinancial sectors in Bangladesh. The most plausible
explanation behind this choice is that the averaging technique of this method makes valuation of
inventories convenient during times of volatile price changes. However, this study does not claim
that the Weighted Average-Cost method is an optimal choice for inventory valuation in
Bangladesh. The present study also reports the use of alternative inventory costing methods across
various sectors, which can be justified on the basis of different business circumstances. Yet, a
noteworthy difference is observed wherein some firms adopted different valuation techniques
despite being from similar industries. Such cases of discord imply that harmonization of
accounting practices are not being completely ensured in Bangladesh. Institute of Chartered
Accountants in Bangladesh (ICAB) and government agencies like Security and Exchange
Commission (SEC) therefore needs to establish new rules in order to standardize the use of
inventory costing methods within similar sectors of Bangladesh. Institute of Chartered
Accountants in Bangladesh (ICAB) should also review the current practices of inventory valuation
for all companies in Bangladesh. The results of this study claim a consistent application of
inventory costing methods among majority of the selected companies in the sample.

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8.0 REFERENCE

Staff, Investopedia. "Inventory Valuation For Investors: FIFO And LIFO". Investopedia. N.p,
2017. Web. 5 Apr. 2017. <http://www.investopedia.com/articles/02/060502.asp>

"Effects Of Inventory Accounting". Investopedia. N.p., 2017. Web. 5 Apr. 2017.


<http://www.investopedia.com/exam-guide/cfa-level-1/assets/inventory-accounting.asp>

"Impacts Of Costing Methods On Financial Statements". Boundless. N.p., 2017. Web. 5 Apr.
2017. <https://www.boundless.com/accounting/textbooks/boundless-accounting-
textbook/controlling-and-reporting-of-inventories-5/valuing-inventory-36/impacts-of-
costing-methods-on-financial-statements-216-3778/>

"Sector Wise Company List". Dsebd.org. N.p., 2017. Web. 5 Apr. 2017.
<http://www.dsebd.org/by_industrylisting1.php>

Nabila Nisha, 2015. Inventory valuation practices: A developing country perspective, International
Journal of Information Research and Review. Vol. 2, Issue, 07, pp. 867-874, July, 2015.

Mia, Md. Abdul Hannan. INVENTORY VALUATION AND IAS-2 COMPLIANCE In


Bangladeshi Manufacturing Industries. 1st ed. Dhaka: ICMAB, 2016. Web. 5 Apr. 2017.

Chung, S. and Narasimhan, R. 2003. An empirical analysis of the inventory accounting methods
of U.S. multinational companies: Segment and industry effects, paper presented at the
Seventh International Conference on Global Business and Economic Development,
January 2003, Bangkok, Thailand.

Larson, Kermit D. Financial Accounting - Information For Business Decisions. 1st ed. McGraw-
Hill, 2017. Print.

Annual Reports of multiple companies.

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